Prologue
Stan O’Neal wanted to see him. How strange. It was September 2007. The two men hadn’t talked in years, certainly not since O’Neal had become CEO of Merrill Lynch in 2002. Back then, John Breit had been one of the company’s most powerful risk managers. A former physicist, Breit had been the head of market risk. He reported directly to Merrill’s chief financial officer and had access to the board of directors. He specialized in evaluating complex derivatives trades. Everybody knew that John Breit was one of the best risk managers on Wall Street.

But slowly, over the years, Breit had been stripped of his authority—and, more important, his ability to manage Merrill Lynch’s risk. First O’Neal had tapped one of his closest allies to head up risk management, but the man didn’t seem to know anything about risk. Then many of the risk managers were removed from the trading floor. Within the span of one year, Breit had lost his access to the directors and was told to report to a newly promoted risk chief, who, alone, would deal with O’Neal’s ally. Breit quit in protest, but returned a few months later when Merrill’s head of trading pleaded with him to come back to manage risk for some of the trading desks.

In July 2006, however, a core group of Merrill traders had been abruptly fired. Most of the replacements refused to speak to Breit, or provide him the information he needed to do his job. They got abusive when he asked about risky trades. Eventually, he was exiled to a small office on a different floor, far away from the trading desks.

Did Stan O’Neal know any of this history? Breit had no way of knowing. What he did know, however, was that Merrill Lynch was in an awful lot of trouble—and that the company was still in denial about it. He had begun to hear rumblings that something wasn’t right on the mortgage desk, especially its trading of complex securities backed by subprime mortgages—that is, mortgages made to people wuth substandard credit. For years, Wall Street had been churning out these securities. Many of them had triple-A ratings, meaning they were considered almost as safe as Treasury bonds. No firm had done more of these deals than Merrill Lynch.

Calling in a favor from a friend in the finance department, Breit got ahold of a spreadsheet that listed the underlying collateral for one security on Mer­rill’s Merrill’s books, something called a synthetic collateralized debt obligation squared, or synthetic CDO squared. As soon as he looked at it, Breit realized that the collateral—bits and pieces of mortgage loans that had been made by subprime companies—was awful. Many of the mortgages either had already defaulted or would soon default, which meant the security itself was going to tumble in value. The triple-A rating was in jeopardy. Merrill was likely to lose tens of millions of dollars on just this one synthetic CDO squared.

Breit started calling in more favors. How much of this stuff did Merrill Lynch have on its books? How bad was the rest of the collateral? And when in the world had all this happened? Pretty soon he had the answers. They were worse than he could possibly have imagined. Merrill Lynch had a staggering $55 billion worth of these securities on its books. They were all backed by subprime mortgages made to a population of Americans who, in all likelihood, would never be able to pay those loans back. More than $40 billion of that exposure had been added in the previous year, after he had been banished from the trading floor. The reckless behavior this implied was just incredible.

A few months earlier, two Bear Stearns hedge funds—funds that contained the exact same kind of subprime securities as the ones on Merrill’s books— had collapsed. Inside Merrill, there was a growing nervousness, but the leaders of the mortgage desk kept insisting that its losses would be contained— they were going to be less than $100 million, they said. The top brass, including O’Neal, accepted their judgment. Breit knew better. The losses were going to be huge—there was no getting around it. He began to tell everybody he bumped into at Merrill Lynch that the company was going to have to write down billions upon billions of dollars in its subprime-backed securities. When the head of the fixed-income desk found out what Breit was saying, he called Breit and screamed at him.

Stan O’Neal had also heard that Breit had a higher estimate for Merrill Lynch’s potential losses. That is why he summoned Breit to his office.

“I hear you have a model,” O’Neal said.

“Not a model,” Breit replied. “Just a back-of-the-envelope calculation.” The third quarter would end in a few weeks, and Merrill would have to report the write-downs in its earnings release. How bad did he think it would be? O’Neal asked. “Six billion,” said Breit. But he added, “It could be a lot worse.” Breit had focused only on a small portion of Merrill’s exposure, he explained; he hadn’t been able to examine the entire portfolio.

Breit would never forget how O’Neal looked at that moment. He looked like he had just been kicked in the stomach and was about to throw up. Over and over again, he kept asking Breit how it could have happened. Hadn’t Merrill Lynch bought credit default swaps to protect itself against defaults? Why hadn’t the risk been reflected in the risk models? Why hadn’t the risk managers caught the problem and stopped the trades? Why hadn’t Breit done anything to stop it? Listening to him, Breit realized that O’Neal seemed to have no idea that Merrill’s risk management function had been sidelined.

O’Neal went back to his desk to contemplate the disaster he now knew was unavoidable—not just for Merrill Lynch but for all of Wall Street. John Breit walked back to his office with the strange realization that he—a midlevel employee utterly out of the loop—had just informed one of the most powerful men on Wall Street that the party was over.

Excerpted from "ALL THE DEVILS ARE HERE: THE HIDDEN HISTORY OF THE FINANCIAL CRISIS" by Bethany McLean and Joe Nocera by arrangement with Portfolio, a member of Penguin Group (USA), Inc., Copyright (c) Bethany McLean and Joe Nocera, 2010.

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Editor's note:
This image contains graphic content that some viewers may find disturbing.